ECONOMIC POLICY

Part. I, Unit 3

J.M. Keynes’ “General Theory” and its

influence on the XX century policy debate

• As already mentioned, classical and neo-classical (pre-keynesian) economists maintained that market mechanisms, provided that free competition held, were able to ensure an optimal allocation of resources and full employment

• In the Walras-Pareto general equilibrium models, prices adjust very rapidly (instantaneously) in order to bring equilibrium both the markets for productive services and for consumer commodities

• L. Walras (1834-1910): The role of government is to guarantee the legal framework for free competition. In particular, it should:

• i) guarantee the enforcement of contracts and the security of private property;

• ii) dismantle monopolies (natural monopolies should be nationalized).

• Discretionary monetary and fiscal policies are not even contemplated.

More generally, in the neoclassical (pre-keynesian) models full employment was taken for granted

According to the “Say’s Law”, supply created its own demand

Household’s income was either spent ( C ) or saved ( S )• Y = C + S

Furthermore, whatever was saved by households, was invested in productive projects:

• S = IExcess supply or insufficient demand were ruled out by

definition. In the classical/neoclassical world nothing is hoarded or lies idle

• During the 1930s, however, the classical/neoclassical model appeared unable to explain the Great Depression, characterized by an unprecedented worldwide downturn of economic activity and prices and by high and persistent unemployment

• Keynes’ General Theory (1936): a remarkable intellectual effort to explain and counteract this unprecedented crisis

• In Keynes’ words:

• “The composition of this book has been for the author a long struggle of escape […] from habitual modes of thought and expression […] The difficulty lies not in the new ideas, but in escaping from the old ones, which ramify into every corner of our mind” (K., 1936, p. viii)

The General Theory includes two parts:

Part I (chapters 1-18) is a fixed price model. By adopting a partial equilibrium approach, Keynes analyses in sequence the following markets:

• the labour market (chapter 2)• the goods market (chapters 3-10)• the capital market (chapters 11-12• the money market (chapters 13-17)

Part II (chapters 19-21): Keynes generalizes the previous model by assuming flexibility of wages and prices

• The labour market

Keynes summarizes the classical theory of employment which was based on two postulates:

• the wage is equal to the marginal productivity of labour (N);

• the utility of wage is equal to the marginal disutility of employment

Let’s draw a Cartesian coordinate plane (vertical axis W/P and horizontal axis N). Assuming that:

i) the marginal productivity of labour is decreasing;

ii) the marginal disutility of labour is increasing,

the Classical economists were able to draw Nd (labour demand) and Ns (labour supply) as, respectively, a downward sloping and an upward sloping curve

Equilibrium real wage and employment were uniquely defined by the interaction of Nd and Ns

In the Classical analysis unemployment was basically “voluntary” unemployment. This was due “to the refusal or inability of a unit of labour, as a result of legislation or social practice or of […] collective bargaining or of slow response to change or of mere human obstinacy, to accept a reward corresponding to the value of the product attributable to its marginal productivity” (K., 1936, p. 6)

The Classical model was also compatible with “frictional” unemployment.

It did not admit on the contrary “unvolontary” unemployment.

In his analysis Keynes maintained that only the first postulate was correct: the supply of labour, on the contrary, was indeterminate:

Reasons:

i) Labour contracts are stipulated for money wages (W) rather than for real wage (W/P)

ii) If W production costs P : “there may exist no expedient by which labour as a whole can reduce its real wage to a given figure by making revised money bargains with the entrepreneurs” (Keynes, 1936, p. 13)

As a consequence the labour market was indeterminate: in Keynes’ view the level of employment was a function of the aggregate demand.

The goods market and the capital market• As mentioned before, in the classical and

neoclassical models aggregate supply creates by definition its own demand: the goods market is always in equilibrium (“Say’s law”)

Keynes maintained on the contrary that aggregate demand could be insufficient and that this indeed was case during the Great Depression

In the General Theory he analyzed separately

i) consumption; ii) investment

i) Consumption: is a function of the disposable income and is fairly stable

ii) Investment: according to Keynes (and to I. Fisher) investment decisions depend on the present value of the flow of profits a firm can expect from a particular investment versus its cost

Investment depends therefore on current interest rates, and on expectations of the future

Crucial point: according to Keynes the “basis of knowledge on which estimates of perspective yields have to be made” are extreme precarious:

“we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, an Atlantic liner […] amounts to little and sometimes to nothing” (K., 1936, pp. 149-50)

The role of the “animal spirits”:

“In former times […] investment depended on a sufficient supply of individuals of sanguine temperament and constructive impulses who embarked on business as a way of life, not really relying on a precise calculation of perspective profit. The affair was partly a lottery though with the ultimate result largely governed by whether the abilities and character of the managers were above or below the average”

“If human nature felt no temptation to take a chance, no satisfaction (profit apart) in constructing a factory, a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation” (K., 1936, p. 150)

The unfortunate consequence, however, was that:

“economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average business man”

Therefore, the fear of a Labour government, or of a New Deal can cause a collapse of investment simply because upsets “the belicate balance of spontaneous optimism”

If business men were reluctant to invest, government had to take the lead by adopting deficit spending policies aimed at improving the country’s infrastructure

Unfortunately, this was rarely the case: indeed, Keynes observed, “wars have been the only form of large-scale loan expenditure which statesmen have thought justifiable” (K., 1936, p. 130)

The money market

In the classical model, the only function of money was that of medium of exchange

The demand for money was the following:• Md = kPY• 0k1

Keynes focused his analysis on the role of money as a store of value: money indeed was by definition the asset characterized by the highest degree of liquidity

Demand for money in terms of liquidity preference

During a depression people had an obvious incentive to postpone investment and consumption decisions and to scramble for liquidity. This tendency, however, had the very unfortunate consequence of worsening the downturn of economic activity

“Unemployment develops, that is to say, because people want the moon: men cannot be employed when the object of desire (i.e. money) is something which cannot be produced and demand for which cannot be readily chocked off”

In Keynes’ view the rate of interest is “the reward for parting with liquidity for a specific period” (K., 1936, p. 167)

The demand for money is a function of both income (direct relation) and the interest rate (inverse relation)

The money supply is exogenous (the amount of liquidity is determined by the Central bank)

In Keynes view, the transmission mechanism of monetary policy is basically indirect:

• provided that the demand for money is stable, an increase in money supply (Ms) would cause a reduction of the interest rate (i), an increase in investment (provided that expectations do not

change) and an increase in aggregate demand

This mechanism, however, can become ineffective as a consequence of two factors:

• high interest rate elasticity of the demand for money (extreme case: the liquidity trap)

• adverse expectations in the business sectors.

In these circumstances monetary policy is totally ineffective: in order to get out of the recession, governments have to adopt expansionary fiscal policies

Keynes’ General Theory was a watershed in XX century economic policy

However, the mainstream macroeconomic theory that emerged in the early 1950s (and remained dominant till the early 1970s) was actually a synthesis based on the ideas of Keynes and earlier economists (the so called neoclassical synthesis)

The neoclassical syntesis was the result of the work of such authors as J. Hicks, A. Hansen, P. Samuelson, F. Modigliani, D. Patinkin• .

The most influential formalization of Keynes’s ideas was the IS-LM model, developed by John Hicks and Alvin Hansen in the 1930s and early 1940s.

Policy discussions became organized around the slopes of the IS and LM curves.

Another influential tool elaborated by the Keynesian economists after WWII was the Phillips curve

The Phillips curve was “discovered” in 1958 as an empirical relation between the rate of unemployment and the rate of inflation

In 1960 the economists P. Samuelson and R. Solow replicated Phillips exercise using U.S. data

They identified a stable, negative relation between u e π (rate of inflation):

[1] πt = α ut

This relation implied that the governments were able to choose between different combinations of unemployment rates and inflation rates

During the 1960s the Keynesian model and the Phillips curve were severely criticized by Milton Friedman, the leader of the monetarists